Emerging Market Equity Allocation Model for Q2 2014

EM and DM equities diverged in 2013, as MSCI EM (-5.1%) and MSCI DM (+23.7%) moved in opposite directions for the first year since 1998. This divergence has ended (for now) in 2014, with MSCI EM at -4.9% YTD and MSCI DM at -0.9% YTD. So far this year, the modest positive performance of the US (+0.5%) has been counterbalanced by the negative performance of Europe (-1.0%) and Japan (-8.8%). We note that MSCI indices measure dollar returns, taking into account both equity and FX movements for dollar-based investors.

Within EM, there has also been greater divergence of returns, continuing the trend that began in 2012 after two straight years of highly correlated EM returns. The standard deviation of MSCI country returns within EM was near 20% in both 2012 and 2013, the highest since 2009. However, this falls well short of the average standard deviation near 29% dating back to 1996. So far in 2014, the standard deviation of EM returns stands just above 9%, and is above the 7.9% that we saw in Q1 2013

We view Q1 2014 as a potential turning point for EM this year, just as the May 22 Bernanke speech on tapering was last year. In recent weeks, EM has digested the start of Fed tapering, devaluations in Argentina and Kazakhstan, the Crimean crisis, a deeper than expected China slowdown coupled with a shift in its FX regime, and now potentially earlier than anticipated Fed rate hikes.

Yet EM currencies for the most part have not revisited their January lows. While we began this year very negative on EM for much of 2014, the recent price action must be respected. With currency valuations cheap and fundamentals still strong for the most part in EM, we think investors are looking at a good window of opportunity for EM assets through much of 2014.

MODEL DESCRIPTION

Our equity allocation model is meant to assist global equity investors in assessing relative sovereign risk and optimal asset allocation across countries in the EM universe. The countries covered include 20 of the 21 countries in the MSCI EM Index as well as 3 (Israel, Hong Kong, and Singapore) from the MSCI DM Index and 2 (Argentina and Pakistan) from the MSCI Frontier Markets Index.

A country’s score reflects its relative attractiveness for equity investors – the likelihood that its equity market will outperform the rest of our EM universe over the next three months.

A country’s score is determined as a weighted composite of 15 economic and political indicators that are each ranked against the other 24 in our model EM universe. Categories are industrial production growth, real interest rates, export growth, expected P/E ratio, real bank lending, current account, real money growth, GDP growth, investment, per capita GDP, inflation, retail sales, index of economic freedom, FDI, and ease of doing business.

A country that is typically ranked first in many of the categories will end up with a low composite score (the lower the better). Exchange rate fluctuations can have significant effects on the dollar return to foreign investors, and so we have chosen several variables that tend to highlight exchange rate risk. Others were chosen as leading indicators of economic growth.

Within our model universe of 25 EM countries, those five that were at the top of our rankings with a 1 rating (VERY OVERWEIGHT equity position) fell an average -2.4% during this period. Those with a 2 rating (SLIGHTLY OVERWEIGHT) rose an average 1.5%, while those with a 3 rating (NEUTRAL) rose an average 1.0%. This compares to an average loss of -0.2% during the same period for those with a 4 rating (UNDERWEIGHT) and an average loss of -1.3% for those with a 5 rating (VERY UNDERWEIGHT).

At first blush, our equity model had decent results this past quarter in identifying equity outperformers and underperformers. We do note that very strong performances for 5-rated Egypt (up 10.5%) helped skew the results a bit on the bottom end. A very weak performance for 2-rated Russia (-15.6%) and 1-rated China (-4.5%) helped skew the results on the top end. Netting them out of their respective categories led to an average loss of -4.2% for the 5-rated group, an average gain of 5.1% for the 2-rated group, and an average loss of -1.8% for the 1-rated group.

Even with those adjustments, our model performance was not quite as strong as we would have liked for this past quarter. Over the long run, our model has shown a more consistent ability to pick winners and losers, and believe that will be the case for the rest of 2014 despite these mixed results for Q1 2014.

2014 EM EQUITY OUTLOOK

We remain cautiously optimistic on EM this year. We think that portfolio adjustments favoring DM at the expense of EM have likely reached or are close to reaching their end. As such, we believe that the two indices should remain highly correlated and no longer diverging, with 2013 seen as a clear outlier.

While the Fed has taken pains to stress that tapering is not tightening, we believe investors are starting to prepare for the risk that the rate hike cycle will start earlier than the Q3 2015 thought before Yellen’s recent statements. While the eventually Fed tightening cycle will likely disrupt global markets again, we do think that EM has several quarters ahead of relatively smooth sailing. This is predicated, of course, on the assumption that the Crimean crisis will fade and China does not experience a hard landing with systemic risks.

Under these assumptions, we believe it will be very important for investors to continue focusing on the fundamentals. We continue to believe that countries with weak fundamentals and poor growth outlooks will suffer more this year. Our 5-rated grouping for Q2 2014 consists of Brazil, India, Egypt, South Africa, and Pakistan. Conversely, our 1-rated grouping for Q2 2014 consists of Singapore, Hong Kong, China, Peru, and Russia.

The inclusion of China and Russia in the top rung for this current round is noteworthy given the heightened risks in those two countries. However, we accept this ranking in light of our assumptions for lessened tail risk in both. Noteworthy too is Turkey moving up to 2-rated from 3-rated previously and Hungary moving up to 3-rated from 5-rated previously. These two were also poor performers in Q1, and so cheap valuations could help make them attractive too. Lastly, Indonesia has moved down to 4-rated from 2-rated previously, and follows a period of strong outperformance in Q1. Indeed, it was the top performer in our model.

MSCI recently indicated that it was considering including China’s A-shares (yuan-denominated mainland shares) into its Emerging Markets equity index. MSCI plans on consulting with 2000-3000 fund managers, with a decision expected in June. The early results are thought to be mixed. While some fund managers are sympathetic, others have reportedly expressed concern about the investment quotas, the capital gains tax, and capital controls.

China’s stock market capitalization is about $3.3 trln and is the fifth largest in the world. MSCI estimates that some $12 bln could flow into China stocks if it were to be included in its indices, with $8 bln going into the MSCI Emerging Market equity index. Private sector estimates tend to be considerably smaller.

Win Thin is the Head of Emerging Markets Currency Strategy at Brown Brothers Harriman. He has a broad international background with a special interest in developing markets. Win received his Ph.D. in economics from Columbia University in 1995, specializing in international and development Economics. He received an MA from Georgetown University in 1985 and a B.A. from Brandeis University 1983.